1031 Exchanges and Small Investors
Don’t know what a 1031 Exchange is and what the associated benefits are? – You’re not alone. The 1031 Exchange has been around since 1921 but most people are just learning what it is, why it’s valuable and how it works to your advantage.
Short and simple, section 1031 of the IRS code allows you to defer capital gains taxes if you use the proceeds from the sale of one investment property or business-use property to reinvest in another “like kind” property.
It might help to view a 1031 exchange like a 401K where you put tax-free money away and watch it increase – the same applies to a 1031 exchange. Rather than selling one investment property, putting the profits in a bank account and paying large amounts in capital gains taxes and depreciation you can use a 1031 Exchange to maximize your investment power by deferring your tax liability on the sale.
Using a 1031 Tax Exchange, you can use pre-tax income to purchase investment property by placing the profits from the sale of your current investment or relinquished property into an escrow account with a qualified 3rd party and then purchase a “like-kind” property or replacement property. If the transaction is managed correctly, taxes on the sale are delayed until the new investment property is sold without reinvesting in another like-kind property.
The thinking behind this section of tax code is that since you are just switching one property out for another there has been no economic gain - just a transfer of where the value resides and therefore no taxes are owed on this transaction.
Don’t let the term “like-kind property” deceive you. Since this term is not defined in the tax code it has taken on a broad definition that refers to “the nature of character of the property and not to its grade or quality” by the Treasury Regulation.
This means a 3 bedroom investment property can be traded for an 8 bedroom investment property, a farm can be traded for an office complex, vacant land can be traded for income property, and a rental property can be traded for your future retirement home of your dreams while producing income in the interim. A 1031 Exchange doesn’t only apply to real estate. You can exchange planes, livestock, furniture, and equipment as well as long as the items are within the same asset class.
The 1031 Exchange is also a valuable strategy to planning your estate since the tax obligation is excused when the investor is deceased. This means if that if carefully executed and properly planned you won’t ever have to pay back the capital gains taxes and your beneficiaries won’t be responsible for paying them back either.
There are some disadvantages to the 1031 Exchange that include restricted access to the proceeds of the sale which must be held in escrow by an eligible intermediary, rigid time limitations with no extensions available that require you to ascertain the replacement property within 45 days of the sale of your property and to close on the replacement property within 180 days. Exclusions under the code that do not qualify for a 1031 Tax Exchange include personal use property such as second homes or vacation homes, and stocks as well as others specified in the code.
Careful planning and professional counsel from a qualified tax advisor and/or attorney with a thorough understanding of tax law is important to properly executing a 1031 Tax Exchange and navigating this loophole to work in your favor.
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